NASD Requests Comment on Proposed Amendments to Rules 1014 and 1017

REQUEST FOR COMMENT

Membership Application Rules

Comment Period Expires: September 20, 2002

Executive Summary

NASD requests comment on proposed amendments to Rules 1014 and 1017. Rule 1017(a) sets forth certain events relating to changes in a member's ownership, control, or business operations, which require a member to apply and obtain approval from NASD staff.¹Rule 1014 establishes the standards for approval of both new member applications under Rule 1013 and "continuing member applications" under Rule 1017. NASD is proposing amendments to Rules 1014 and 1017 to clarify and further strengthen NASD's authority under these rules in an effort to stay abreast of market developments.

Specifically, NASD has experienced an increase in member consolidations, business restructurings, and asset sales. NASD has reviewed proposed transactions that could have an adverse effect on the payment of arbitration awards and satisfaction of other customer claims. To address concerns raised in such transactions, NASD seeks comment on amendments to Rules 1014 and 1017 that would: (1) expand NASD's authority to review asset transfers to include any transfer involving a material amount of assets and/or revenues that contribute materially to earnings; (2) require that any seller that is not a member of the New York Stock Exchange (NYSE) file an application for asset transfers covered by the rule even in the case where the buyer to the transaction is an NYSE member (which currently is a situation excluded from review under Rule 1017); and (3) create a new standard of admission explicitly identifying as decisional criteria unpaid arbitration awards or other adjudicated customer awards, as well as pending arbitration claims by an applicant, its controlling persons, principals, registered representatives, any lender of 5% or more of the applicant's net capital, and any other member with respect to which these persons were a controlling person or a 5% lender of its net capital.

In addition, former members or their associated persons with a significant disciplinary history, including a history of unpaid arbitrations, may later seek to re-enter the securities industry. NASD is concerned about the investor protection issues and the potential adverse impact on the integrity of the marketplace posed by these persons. In this regard, as further outlined below, NASD is requesting comments on an amendment that would place the burden on applicants to demonstrate that their applications should be approved notwithstanding that the applicant has a history of certain regulatory events.

NASD further seeks comment on whether Rule 1014 should be amended to include reference to entities as controlling persons in light of the fact that NASD's current definition of "associated persons" does not include non-natural persons.

Questions/Further Information

Questions regarding this Notice to Members may be directed to the NASD Office of General Counsel, Regulatory Policy and Oversight, at (202) 728-8071; or the NASD Member Regulation Department, Regulatory Policy and Oversight, at (202) 728-8221.

Request for Comment

NASD requests comment on the proposed amendments to Rules 1014 and 1017 described in this Notice. For your convenience, we have provided a checklist (see Attachment B) that offers a convenient method to participate in the comment process concerning the proposed amendments.

Comments must be received by September 20, 2002. Members and interested persons can submit their comments using the following methods:

• mail Attachment B—Request for Comment Form—along with written comments



• mail written comments



• e-mail written comments to [email protected]



• submit written comments online on our Web Site (www.nasd.com)

Written comments submitted via hard copy should be mailed to:

Barbara Z. Sweeney
NASD
Office of the Corporate Secretary
1735 K Street, NW
Washington, DC 20006-1500

Important Note: The only comments that will be considered are those submitted by mail, e-mail, or those submitted to the NASD Web Site.

Before becoming effective, any rule change developed as a result of responses received to this Notice must be approved by the Securities and Exchange Commission.

Background

The membership application and membership continuation processes have played an important role in investor protection by helping to ensure that new members and members that make a material change to their business comply and continue to comply with rigorous standards. Rule 1014, which sets forth the standards used when reviewing new member and continuing member applications, specifically requires NASD to consider the public interest and protection of investors when reviewing applications.

Recently, there has been an increase in company restructurings, including the selling of company assets. Asset transfer applications filed pursuant to Rule 1017 are often time-sensitive and may be the first step in a member's withdrawal from the securities business. While asset transfers often serve legitimate business purposes, they also can raise customer protection issues. NASD has encountered several instances where the effect of a member attempting to restructure by transferring assets is to insulate the member and its owners from responsibility for payment of pending or unpaid arbitrations. In some cases, the member will transfer its assets without a corresponding transfer of its liabilities.Because the corporate format used by many members seeks to insulate the owners from liabilities of the member, a customer with an award or judgment against the member may only be able to be paid from the member's assets. Thus, an asset transfer may transform the member from an operating business that can generate value over time to a shell holding the firm's liquidated value, leaving behind customers with arbitration claims pending against, or arbitration awards unsatisfied by, a member.

Discussion

Based on NASD's experience in applying the membership application procedures, especially in light of increasing concerns regarding the potentially negative effects of asset transfers on former and current customers, NASD believes that Rules 1014 and 1017 should be amended to allow NASD to better identify and respond to applications that may leave pending arbitrations and customer claims unaccounted for.

1. Review of Material Transfer of Member's Assets

NASD believes it is important that it has the opportunity to review all member transactions that can materially adversely affect current and former customers. Rule 1017(a)(3) requires a member to submit an application only upon the transfer of substantially all of the member's assets. However, this may potentially eliminate from NASD's review a member's piecemeal transfer of its assets that, while not "substantially all" in amount, may nevertheless have a material impact on the operations or profitability of the selling member. In this regard, NASD proposes broadening the scope of Rule 1017(a)(3) to require members to submit applications prior to the transfer of a material amount of the member's assets or prior to the transfer of any asset, business or line of operation that generates revenues comprising a material portion of the selling member's earnings.² NASD further seeks comment on whether "material" should be more specifically defined in the Rule and, if so, the appropriate standard of materiality. For example, should NASD define "material" for these purposes to be 25% or more of the member's assets or any asset, business or line of operation that generates revenues of 25% or greater of the selling member's earnings. NASD seeks comment on whether some other standard is more appropriate.

2. Clarification of Members Required to Submit Applications

Because of concerns that a selling member's customers may be left unprotected following an asset transfer, NASD believes that the seller's situation should be reviewed in connection with all such transactions. Rule 1017(a) currently exempts selling members from the requirement to submit applications if the acquiring firm is a member of the NYSE. The proposed amendments would require all non-NYSE selling members to submit an application regardless of whether the buyer is an NYSE member. NASD does not intend to put applicants through duplicative approval processes where the transaction is otherwise subject to adequate customer protection safeguards. Rather, in requiring an application regardless of whether the acquirer is a member of the NYSE, NASD will be assured of receiving notice and will be in a position to target particular aspects of the transaction for additional review, if necessary.

3. Consideration of Arbitrations in Application Process

Comporting with NASD's attempts to foster compliance with the terms of arbitration and other adjudicated customer awards, NASD proposes to amend Rule 1014(a)(3) explicitly to include as factors in the consideration of both new and continuing member applications the unpaid arbitration awards or other adjudicated customer awards, as well as pending arbitration claims against an applicant and other persons that may have significant control or influence over the applicant, including its controlling persons, principals, registered representatives, any lender of 5% or more of the applicant's net capital, and any other member with respect to which these persons were a controlling person or a 5% lender of its net capital.³

4. Burden of Proof

NASD has seen instances where an applicant (both new member and change of ownership/control) has a disciplinary history of some concern that falls short of a statutory disqualification. Many of these cases involve applications from closely held firms where, even if the broker/dealer establishes heightened supervisory procedures, the influence of the control person on the small broker/dealer may overcome the supervisory structures. Rule 1014(a)(3) requires NASD to determine whether an applicant and its associated persons "are capable of complying with" federal securities laws and the rules of NASD. A variety of specific events, including past and current disciplinary actions and customer claims, are among the considerations referenced in the rule. However, there is little case precedent to guide NASD in applying this standard, particularly in the context of the key principals and control persons of smaller firms.

NASD is proposing to further enhance its authority under Rule 1014(a), for all categories of applications, to consider the impact of an applicant's past behavior by creating a rebuttable presumption that the presence of any of the events enumerated in Rule 1014(a)(3)(A) and (C) though (E), places the burden on the applicant to demonstrate that the application should be approved notwithstanding the presence of that regulatory history. The rebuttable presumption does not create new standards for admission, but merely shifts the burden of proof to applicants to show that they should be allowed admission. NASD believes that investor protection and service of the public interest demands that applicants with a regulatory history bear the burden of overcoming the rebuttable presumption that their application should be denied.

Additional Issue for Comment

Finally, NASD proposes to amend Rule 1014 to include reference to non-natural controlling persons in light of the fact that NASD's current definition of "associated persons" does not encompass non-natural persons.

Endnotes

¹ The changes requiring application and approval are: mergers, the acquisition of a member, the acquisition of substantially all of a member's assets, a change in ownership or control of a member, and a material change in a member's business operations.

² As with other Rule 1017 applications, Rule 1017(c)(1) allows NASD to place interim restrictions on any asset transfer if NASD believes that the application does not meet Rule 1014 standards. These interim restrictions are meant for the protection of investors and ordinarily would not prevent a transaction from moving forward. However, there may be some instances where the protection of investors will require that interim restrictions will prohibit or delay a transaction from closing.

³ NASD further notes that Rule 2110 applies to efforts by a firm and its owners to unfairly prejudice customers seeking relief in arbitration proceedings.

ATTACHMENT A

New language is underlined; deletions are in brackets.

1014. Department Decision

1017. Application for Approval of Change in Ownership, Control, or Business Operations

ATTACHMENT B

Request For Comment Form

We have provided below a form that members and other interested parties may use in addition to written comments. This form is intended to offer a convenient way to participate in the comment process, but does not cover all aspects of the proposal described in the Notice. We therefore encourage members and other interested parties to review the entire Notice and provide written comments, as necessary.

Instructions

Comments must be received by September 20, 2002. Members and interested parties can submit their comments using the following methods:

• mail Attachment B—Request for Comment Form—along with written comments



• mail written comments



• e-mail written comments to [email protected]



• submit written comments online on our Web Site (www.nasd.com)

Written comments submitted via hard copy should be mailed to:

Barbara Z. Sweeney
NASD
Office of the Corporate Secretary
1735 K Street, NW
Washington, DC 20006-1500

Proposed Amendments to Rules 1014 and 1017

1. Is it appropriate for NASD to review transfers of a material amount of a member's assets or transfers of any asset, business or line of operation that generates revenues comprising a material portion of the selling member's earnings?

2. In connection with the proposed expanded review of asset transfers, should NASD include a more specific standard of materiality in the Rules?

3. Should NASD review other types of transactions that are not currently included in the Rules?

4. Should NASD require all non-NYSE selling members to submit applications to NASD for approval prior to the transfer of assets?

5. (a) Is it appropriate for applicants to bear the burden of proof to demonstrate that they should be approved for membership despite the presence of a regulatory history and,

5. (b) if so, is it appropriate to impose this burden for pending matters such as pending investigations and arbitrations?

6. Should the scope of Rule 1014 be expanded to include non-natural persons?

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